Mad Money

Sector Rotation for Dummies

Spotting a sector rotation, when money moves from one sector or group of sectors into another because of the business cycle, "is of the utmost importance," Cramer said. As far as he's concerned, it’s one of the key moves investors need to spot before it happens if they want to make money in the market.

Ahead of the Curve

Fifty percent of how a stock's price depends upon the performance of the sector it's in, Cramer said. So if investors can call the sector, they can call half the gains or losses in a given stock. Why is this true?

Because most of the big fund managers are committed to sector-based thinking, Cramer said, "and they're the buyers and sellers who set prices."

There are two kinds of companies, cyclical and secular. Cyclical businesses do well when the economy is growing fast and the Fed has rates low, but they don't do so well when the economy slows down. These are the airlines, autos, raw materials, consumer durables and heavy equipment stocks.

Secular stocks aren't sensitive to the underlying strength or weakness of the economy. Think General Mills, Procter & Gamble, Johnson & Johnson or any of the utilities. They won't be affected by the cycle because people don't stop eating or taking their medications just because their cash is running low. 

Here's how to play the cycles: At the top of the cycle, before a downturn is coming, maybe because the Fed is raising rates, load up on your secular stocks, Cramer said. At the bottom, swap out of all that for some beaten up cyclicals. Put simply, when the economy is humming along with high growth, sell cyclicals and buy secular stocks. When GDP growth is in the gutter, but it looks like it’s done going down, that’s the time to load up on cyclicals.

The simple advice is in fact difficult to follow because it's so counterintuitive, Cramer said. When business slows down, cyclical stocks start to bottom, and that's when analysts cut their earnings estimates. But by that point, the company probably won't go much lower. As a result, the stocks look expensive because of their price-to-earnings multiples. Cramer recommended buying at this stage in the cycle because the companies' earnings are going to increase as the economy picks up, and investors won't be able to buy them that low after the market gains some traction.

The bottom line here, though, is to buy secular stocks at the top of the cycle and go on offense with cyclicals when the economy is bad.

"Don't get killed by the idiots out there," Cramer said, "who can't think a little counterintuitively."

Jim's charitable trust owns General Mills.

Call Cramer: 1-800-743-CNBC

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